AlphaBrain

How a Group of Iconoclasts Are Using Cognitive Science to Advance the Business of Alpha Generation

Stephen Duneier

• Publisher: Wiley
• Year: 2019
• ISBN:
  9781119335917
• Edition: 1
• Topic: Business
• Subtopic: Wealth Management
• Index: Business

Smarter decision-making based on cognitive science

AlphaBrain is the investor's guide to achieving more, doing better, and reaching higher. At its core, the magnitude of your success is based on the quality of your decisions. The problem is that human beings are poor decision-makers; we tend to approach problems after they arise instead of planning for them in advance. We put too much weight on instinct, belief, and "gut feeling." We make the same mistakes over and over again—so reliably, in fact, that cognitive science can accurately predict exactly which mistakes we'll make and when. This book offers a way to understand and plan for the human mind's usual tendencies to help you make smarter investment decisions. Using a framework based on cognitive research, you'll learn how to approach decisions objectively, systematically, and constantly review your process; you'll take action based on evidence instead of intuition, and get ahead of potential problems before they get the best of you.

With so much riding on the correctness of your choices, natural tendency can be a dangerous thing. This book shows you how to remove the bias and emotion to start making choices backed by hard evidence and objective data and lower your stress.

• Shift your processes from reactive to proactive
• Base decisions on reality over belief
• Eliminate cognitive bias and reduce common mistakes
• Make better decisions with a systematic, objective approach

Why do we begin managing risk only once it becomes apparent? Why do we react to the market instead of making the big decisions before emotion takes over? Investing has always been a largely reactive field, but those who dominate it approach decision-making less like a human and more like a machine. AlphaBrain shows you how to get real about investing, with cognitive techniques that lead to smarter, evidence-based decisions.

Part I
Decision Analysis

Chapter 1
Marginal Improvement, Significant Impact

Decision‐Making as a Skill

What we do as human beings is make decisions. Whether we are investment managers, athletes, parents, or students, the one true commonality we share is the decision itself. Regardless of the implications, who is making the decision or the field in which it is being made, the decision‐making process always has the same basic components and should always follow the same path.

Decision‐making is a skill. In fact, I would argue it is the skill that we humans possess. However, it is rarely understood to be the underlying source of all other more readily identifiable skills. Instead, we look at a tennis player and think, he is skilled at swinging a racquet or chasing down balls. We look at a politician and think, she is particularly adept at negotiating or salesmanship. We think of successful fund managers and attribute their success to their ability to identify patterns or steel their nerves under pressure. In reality, steeling your nerves is a decision, a skill that can be taught and learned. Swinging a racquet properly and influencing others are decisions as well. They can be taught and learned. They can be practiced and improved via the decision‐making process. When you truly grasp this concept, and are able to properly frame everything by the decision, to view the world through the lens of the decision‐making process, you come to realize that in order to truly excel at anything in life, both personally and professionally, you must focus on the decision as a problem to be solved.

A professional athlete cannot simply turn off the decision‐making process when they aren't on the playing field. To make optimal decisions at the baseline, they must make the right nutritional decisions, practice decisions, footwork decisions, rest decisions, investment decisions, coaching decisions, and so on, even when they are nowhere near the court. To be world‐class tennis stars, they must analyze their decisions, refine them, gather data on them, and approach them deliberately. It is a 24/7 job to reach and maintain their positions as among the greatest players of all time. Same goes for surgeons, actors, and yes, investors.

Becoming a world‐class decision maker isn't a 9‐to‐5 job, it is a lifestyle. It requires not just practice, but repeated, deliberate practice. The kind that requires the employment of cognitive strain, a concept we will return to over and over again throughout this book. It is challenging. It requires sacrifice and a significant investment of time and effort. AlphaBrain is fundamentally a book about how to improve your decision‐making as it applies to institutional investing, but the concepts and the science behind it are applicable to any one of the millions of decisions made on a daily basis by every single one of us in every aspect of our lives.

Spectators in Our Own Decisions

Far more often than any of us would like to believe, we are mere spectators in the decisions we make, even in decisions of great consequence. If we are spectators in the decisions we make, it means we are bystanders, as opposed to the active participants we perceive ourselves to be, in the investments we make, the businesses we run, and even the lives we lead.

I know what you are thinking. You're smart, highly educated, experienced, and very successful. What I am saying doesn't apply to you. As it happens, not only don't those qualities keep us from being spectators or grant us immunity from the problems it can cause, but they often make us even more vulnerable. I understand it may be a difficult pill to swallow, so let's consider a study that might help prove the point.

Professors Brian Wansink and Junyong Kim conducted an experiment among north Philadelphia's moviegoers. To half the participants, they provided a free large bucket of popcorn while the other half received a very large bucket. Half of each group were provided fresh delicious‐tasting popcorn. The other half received 14‐day‐old stale popcorn which participants later rated a 2 out of 10.

If we are rational decision‐makers there are only two primary reasons for us to consume food: we eat to be satiaed and/or because it tastes good. Therefore, if we are active participants in the decisions we make, the size of the portion should not affect how much we eat but the perceived taste should. As it happens, those who received the fresh, delicious tasting popcorn in a very large bucket ate just over 40% more than those who received it in the smaller container. On the other hand, those who were provided with popcorn that they themselves described as “terrible” and “disgusting” in a very large bucket, consumed just under 40% more than those who ate it from the smaller one.

Dr. Wansink has conducted numerous experiments of a similar nature, the most famous one involving bottomless bowls of soup, always delivering similar results. Regardless of the fact that we are awake and aware when faced with choices, very often we don't actively participate in the decisions we make.

Perhaps you are thinking that the poor snacking habits of moviegoers falls short of proving that we are spectators in decisions of great consequence. After all, we go to the movies to escape the real world, so perhaps it's only natural that we would leave our rational decision‐maker hat at home for those couple of hours. Before you summarily dismiss studies regarding eating habits of any kind though, consider this. Excess weight and obesity play a role in roughly 80% of all American deaths and disabilities.

In any event, let's turn our attention to a rather well‐known study involving the entire adult populations of some of the most advanced and highly educated countries in the world as it relates to a decision most would perceive to be of great consequence. Johnson gathered data regarding countrywide organ‐donor participation rates across a number of major Western European countries. In Denmark he found that just 4% of the country's adult population had elected to donate their organs upon death. Meanwhile, right across the bay in Sweden, the participation rate was 86%. Fourteen percent of the citizens of the United Kingdom had volunteered their body parts while just across the English Channel nearly 100% of the French had done so. Perhaps most surprisingly, while only 12% of the German population was willing to donate their internal organs, Austria, a country that shares a language and so many cultural aspects with Germany, and separated only by an imaginary line on the ground, had a participation rate of roughly 100%.

The question that must be asked is, how could the overwhelming majority of the populations in countries that enjoy so many cultural similarities and are geographically connected arrive at polar opposite conclusions regarding a decision of such great consequence? The answer is really quite simple, and yet astonishing. They all approach decisions in exactly the same way. Sounds counterintuitive, right? After all, every individual is considering the same set of relevant factors and has the same two options from which to choose, so how can it be that they could all consider those factors in the same way and yet arrive at polar opposite conclusions?

As it turns out, the countries with low participation rates run “opt‐in” programs. In those countries, if you do not take action (i.e., make a decision), you will not be an organ donor. On the other hand, those with very high participation rates run “opt‐out” programs, meaning if you do not take action you will be an organ donor. In other words, the common bond shared by the great majority of these predominantly educated decision‐makers in some of the most advanced nations on earth is that the overwhelming majority of them are little more than spectators in at least some of their own decisions, even decisions of great consequence.

Of course, if you were to stop an average Austrian on the streets of Vienna, show them these statistics and ask, “Why is it that Austrians are so giving, so selfless?” You can be sure they would tell you about their culture of kindness and compassion. What is very unlikely is that they would tell you the answer is simply that the majority of Austrians don't participate in their own decisions but instead let others choose for them. And yet, that is the reality.

This is significant because if we aren't actively participating in decisions such as how much popcorn we eat or whether to donate our organs, yet these decisions are being made, then someone else must be making them for us. In effect, we are outsourcing some our most important decisions to people and institutions we haven't vetted, typically without even realizing it. For many of your most important decisions, regardless of whether you realize it or not, you aren't the decision‐maker. In the case of the free popcorn, the most influential person in the decision‐making process isn't the moviegoer, but rather it is the person who decides the size of the bucket. For the hundreds of millions of adults around the world who are or are not organ donors, the most influential person in the decision was not the potential donor, but the person who framed the question as opt‐in or opt‐out. Consider that for a moment. The difference between hundreds of millions of lives being saved versus lost is affected by individuals who no one knows, no one voted into office, and no one vetted for their qualifications and beliefs. In fact, it's very likely even they don't appreciate the power they wield. After all, everyone is free to make their own choice. The question maker's only input is to ask, “If you would like to be an organ donor, check here” versus “If you would not like to be an organ donor, check here.”

When studies like these brought to light just how little decision‐makers participate in their own choices, it was a game changer. Whereas in the past, corporations and government entities would attempt to educate workers on things like the value of saving for retirement and rainy days, it became apparent there is a much more effective and efficient way to get people to make decisions in their own best interest while still allowing them to exercise free will. Simply reframe the question when they enroll in savings plans. Rather than asking if they'd like to participate in a savings plan, the default is to deduct the maximum amount from their paycheck each month. If they would like to opt out, they must check a box. That seemingly inconsequential adjustment can be the difference between an entire population needing a government‐funded social safety net or not.

What we've discovered as a result of decades of research in the cognitive sciences is that humans make decisions in fairly predictable ways, where even the smartest, most educated, experienced, and successful among us are unconsciously affected by things that have the potential to produce systematic errors in our judgment. Marketers are well aware of this and have been capitalizing on it for generations. Now that policymakers h...